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1 Ecosystems Mini Project Apple in the Digital Music Industry Matthew Hooks, Parrish Isaacs, Eli Miles, Micah Moreau The Advent of the Digital Music Industry Prior to the digital age the music industry value chain was comprised of creative agents (i.e. musicians, sound engineers), music agents (i.e. artists managers, record companies), distribution (i.e. concerts, retail music outlets) and consumers. Record companies controlled the content and were responsible for the distribution, and held supplier power as a result. Music artists could not get their content to the masses without interacting with record companies. Additionally, the masses could not get content without going through one of the record companies distribution partners. In July 1999, Napster emerged onto the scene and changed many of the established dynamics within the music industry. Originally, Napster operated a file-sharing internet site which allowed members to browse other members music libraries and make copies of their digital music files. Under this new model, consumers had access to content created by record labels as well as underground content, content that record labels did not control. At its peak in 2001, Napster had 13.6 million U.S. users. 1 Napster s success garnered the attention of entrepreneurs looking to replicate its digital music model, giving rise to companies such as Morpheus, Kazaa, and Audiogalaxy. More importantly, Napster s success also caught the attention of the Recording Industry Association of America (RIAA), a 1 Canberra Times, 2002, Napster RIP Rest In Pieces, George Cho

2 trade group that represents the Unites States recording industry and the National Music Publishers Association (NMPA), a trade group for music publishers in the United States. In December 1999 the RIAA filed a lawsuit on behalf of its member companies charging Napster with contributory and vicarious copyright infringement. This would be the beginning of an ongoing battle between the RIAA and NMPA against companies such as Napster. This new music distribution model threatened the existing business model and the longevity of the music industry as it took away some of the record companies supplier power. The sentiments of the record companies and its artists can be seen in the following quote by Edward Murphy, CEO of NMPA: The Napster model threatens the livelihood of the people who create music as well as the viability of legitimate Internet music businesses. We hope the Court will act to preserve the rights of songwriters and music publishers, who are being deprived of compensation for their works, and the Internet businesses that have acted responsibly in respecting the creators of music and taken licenses accordingly. 2 The RIAA and NMPA successfully defeated Napster and aggressively sought to disband companies who provided a platform for users to illegally download digital music files. However, the hunt didn t stop with companies. In 2003, the RIAA started to sue individuals by pressuring Internet Service Providers to provide them with the names of individuals who participated in illegal music file sharing, thus further enforcing their position that obtaining music files online without consent was illegal. Simultaneously, however, the popularity of digital music files, both legally and illegally obtained, was continuing to grow, and it increasingly became clear that digital music was here to stay. The traditional music ecosystem was under fire from digital music and changes to its methods of distribution. These changes were revolutionizing the way music was acquired and consumed. Many wondered if there was a way to satisfy the demand for digital music in way that fairly compensated music creators and rightsholders. 2 Apple Launches the itunes Music Store, 2003, Apple Press Release,

3 Apple s Entry into Digital Music In 2000, following the success of the imac computer, Apple began searching for opportunities to develop other electronic devices. Early efforts focused on digital cameras and camcorders, but Apple quickly shifted their focus to digital music players. Competitive digital music players of the time were large, clunky and slow effectively Discman-size, heavy hardware devices that lacked sufficient memory, transfer speed or intuitive operating systems. Sensing an opportunity, Apple set about shrinking the hard drive, improving the connection capabilities and making the operating interface more user-friendly. In October 2001, they launched the ipod. The ipod caught on quickly and by 2004 Apple s market share had grown to 65% of the U.S. market for digital music players. Many factors were responsible for the product s rapid growth. First, the ipod s innovative scroll wheel and software interface made the user experience much more intuitive and efficient. Second, ipod consistently pushed the accepted size and storage limits of electronics by making each generation of ipod both smaller with larger storage capacity. Starting with the original First Generation ipod released in 2001, which measured approximately 2.5 inches by 4 inches, Apple progressively shrunk the ipod to its smallest line, the Second Generation ipod Shuffle, which measured approximately 1 inch by 1.5 inches. Additionally, within the ipod Classic line, Apple was able to increase storage from 10GB in the First Generation model to 160GB in the Sixth Generation. Importantly, from the beginning, Apple ensured that the ipod worked seamlessly with itunes. CEO Steve Jobs original vision for the interaction between the ipod and itunes was summed up succinctly by him in an interview with Fortune magazine: Plug it in. Whirrrrrr. Done. Effectively, Apple was able to transition itunes from standalone digital music management software into the software used to manage everyone s ipod. This integration was critical to the spread of itunes because it required that everyone owning an ipod download and use itunes to manage his/her music. Thus, as the

4 ipod became the dominant digital music player, itunes simultaneously became the dominant music management software. Apple also helped spread of the ipod and itunes by eventually making the hardware and software compatible with PCs and offering itunes as a free download. This was a departure from the traditional Apple model of developing hardware and software that only worked with Macs, but it increased the number of people able to purchase ipods and the number of people subsequently using itunes as their music management software of choice. The free software was the enabling technology that allowed everyone to use Apple s ipod as their digital music player. By this point, the music ecosystem was shifting away from traditional end-uses and towards digital music players like the ipod. However, the distribution problem had yet to be worked out. By 2004, the ipod had become established as the dominant digital music player in the market. At the same time Apple had dramatically increased the penetration of itunes software onto both Macs and PCs. While itunes was not, at the time, providing large revenue streams independent of ipod sales, the company now had a platform in place that would revolutionize the music industry.

5 itunes and the New Music Distribution Model In April of 2003, Apple launched itunes version 4 and the Apple itunes Music Store., which revolutionized the manner in which music was distributed and acquired 3. At the time, the RIAA s continued prosecution of individuals who illegally downloaded music produced a huge backlash from consumers. 4 This forced musicians to choose sides against each other siding with the plight of fans, or with the governing bodies who had traditionally been their only avenue for distribution and monetization of content. More importantly, it provided the impetus for Apple to credibly approach many of the world s largest music publishers with a new method for selling music. Apple intended to offer a digital service allowing fans to download music, but providing the RIAA compensation for downloading the music; legal digital music downloads. To truly make this idea work Apple partnered with music companies, including BMG, EMI, Sony Music Entertainment, Universal and Warner to provide an initial library of 200,000 songs. 5 RIAA concerns about illegal downloads were assuaged as each downloaded song provided a royalty fee payment to the music publisher. In addition, the sometimes contentious atmosphere between artists and fans dissipated once consumers accepted the notion of paying for music and embraced the functionality of the itunes store. itunes 4 was the first version of itunes to include a music store for fans to legally download songs for $0.99 per track, selling over 1 million tracks in the first week alone. Originally launched only for Mac users, Apple quickly introduced a Windows version of the store in October 2003, paving the way for digital distribution ubiquity by Apple. 6 Apple had significantly disrupted the music ecosystem by being the first retailer to offer direct, legal purchase of digital music. 3 The Complete itunes History, Year-Old Sued for Music Downloading, 5 itunes Music Store Sells Over One Million Songs in First Week, 2003, Apple Press Release, 6 The Complete itunes History,

6 Technically, itunes users could buy and download songs for use on a limited number of computers and an unlimited number of ipods. However, per the RIAA s stipulation, purchased songs from the itunes Store were copy protected with Apple's FairPlay digital rights management (DRM) system. This system allowed protected songs to be played on up to five computers at one time, and an unlimited number of Apple supported devices namely, the ipod. DRM protected songs could only be played on computers authorized by the purchaser's itunes account and with itunes 4, all songs downloaded through itunes were DRM protected. 7 This assuaged the RIAA s concern about the potential for legally downloaded music to proliferate on other computers (or devices) illegally. More importantly, however, DRM protection allowed Apple to mitigate competitive risk in the music distribution, storage and playback device markets. DRM protection provided Apple with an incubation period to help establish the ipod as the most dominant playback device on the market. Songs purchased from the itunes store were DRM encrypted and could only be played on itunes or the ipod. 8 This, coupled with the RIAA s continued threat of prosecution against illegal music downloads, limited the ability of competing devices to gain significant traction. In addition, the vertically integrated nature of the ipod provided a key competitive advantage against any potential competitors

7 Prior to the itunes music store, itunes was simply a storage and playback mechanism for a computer. The ipod was essentially a portable storage and playback music device. The advent of the itunes store allowed users to fully integrate the music purchase, storage and playback process into one process. The original version of itunes was simply an enhanced version of WinAmp, with playback coming either from a computer, or portable playback coming in the form of a readable/writable CD. The introduction of the ipod changed the nature of portable playback but did not solve the purchase and aggregation issues inherent in (legally) downloading music. The itunes store allowed users to forego the traditional legal process of purchasing an entire album, burning it onto a computer, loading the songs into itunes, and then syncing itunes with their ipod. The itunes store eliminated the need for physical album purchase, vertically integrating the user experience for ipod owners. The enhanced portability of the ipod, coinciding with the launch of the ipod nano in 2005, solidified Apple s reign as king of the portable music player. The value of the itunes store to Apple s digital music ecosystem was profound. The ability to easily, legally, and reliably download music had a massive effect on the popularity of both itunes and the ipod, as illustrated by the spike in revenue from ipod sales that coincides with the release of the itunes Store (shown below).

8 Figure 1: Revenue from ipod sales and Music Store sales 9 From Apple s ipod and itunes enjoyed strong market dominance. In September 2007 major record labels began to lash back at Apple as labels wanted to open up competition for their musical services. Record labels saw Amazon as their best shot to increase competition and reduce Apple s ability to reduce royalty rates paid to labels. 10 Amazon s ability to sell digital music posed a significant blow to itunes reign as the dominant digital music marketplace. The threat of Amazon encroaching on itunes dominance, coupled with backlash from consumers who wanted the ability to play purchased digital music on other portable devices caused Apple to reduce the copyright laws inherent in its DRM encrypted song technology in late In April of 2009 the itunes Music Store 9 Data taken from Apple 10-K Annual Reports ( ) 10 Sony Joins Other Labels on Amazon MP3 Store, partner=rssnyt&emc=rss 11 Sony Joins Other Labels on Amazon MP3 Store, partner=rssnyt&emc=rss

9 became DRM-free. 12 The digital music industry has become an open ecosystem with little limitation on the purchase and playback of digital music where individuals can use any combination of retailers and hardware devices. Despite this open ecosystem, Apple still believes that they offer a competitive suite of products. As stated in the 2008 Annual Report: Apple believes it currently retains a competitive advantage by offering superior innovation and integration of the entire solution including the hardware (personal computer, ipod, and iphone), software (itunes), and distribution of content (itunes Store and itunes Wi- Fi Music Store). Furthermore, Apple s strategic focus had already shifted from the ipod, to the iphone thus further integrating Apple s suite of products and capitalizing on the growing spread of digital content and portable online devices. 12

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